Investors cannot expect their bombed-out emerging market fund to come rallying back any time soon despite the cheap valuations on offer, according to Neptune’s Ewan Thompson, who warns his asset class still faces numerous challenges. 
Having been one of the most owned areas of the market prior to and immediately after the global financial crisis, developing markets have endured a particularly rough few years thanks to macro trends such as slowing Chinese growth, falling commodity prices and monetary policies in the US.
This has meant emerging markets equities have been hit particularly hard. Though there has been the odd ‘dead cat bounce’ or relief rally, the IA Global Emerging Markets sector average has fallen 15 per cent over five years.
Performance of sector versus index over 5yrs
Source: FE Analytics
As the graph above shows, those falls have been compounded over the past 12 months or so as fears of a hard-landing in the Chinese economy and a further plunge in the oil price has hurt sentiment towards the already beleaguered area of the market.
This has, however, led to relatively low valuations and coupled with the fact most investor are severely underweight emerging markets in their portfolio, many contrarian managers believe the developing world offers rich pickings for long-term investors given aspects such as favourable demographics and stronger economic growth than you can find in the west.
Thomson, who manages the Neptune Emerging Markets fund, doesn’t think a strong recovery rally is on the cards, however, as major macro trends continue to work against his asset class.
“In our view, what remains wrong with emerging market earnings, ultimately, comes back to the US dollar,” Thomson said.
“Inflation expectations are deteriorating and global liquidity is being withdrawn. If you chart EM’s relative performance over the years, it correlates very strongly with inflation expectations – which makes sense given commodities are a big part of emerging markets.”
“Ultimately, the backdrop for emerging market outperformance we are looking for would be better liquidity (aka a weaker dollar), a pick-up in global trade and rising inflation. Therefore, you have this dollar problem.”
“Over the last five years, we have had these constantly had these short-term rallies in emerging markets but to make them sustainable, we need a weaker dollar.”
The US dollar has been strengthening against most other major currencies for some time now due to the fact the US economy was the first to pull itself out of the global financial crisis. While there has been some weakness of late (thanks to fears of policy error from the US Federal Reserve), many expect it to continue to strengthen over time.
Relative performance of currencies over 3yrs
Source: FE Analytics
Thompson is one manager who sits in that camp.
“We believe the dollar will continue to be in a structural bull market. Now, in that environment of slow global trade and no pick-up in inflation expectations, it’s hard to see any transmission mechanism in a sustained recovery in EM earnings,” he said.
He added: “That’s why it’s really difficult to bang the table and say, go and buy emerging markets right this second.”
Of course, there are many who think a significant buying opportunity in emerging markets thanks to the relatively low valuations on offer.
Simon Evan-Cook, senior investment manager at Premier, for example, recently told FE Trustnet that he has been positive towards emerging markets for a while because of cheap valuations.
“If you’re looking for a macro reason to be bullish on emerging markets there’s the fact that there’s a possibility that US interest rates may not go up at all, or maybe further down the road more QE or stimulus might be administered, which would be quite a relief for emerging markets,” he pointed out.
“That’s are good macro reason for it but we’re not macro investors – it’s the valuations that interest us.”
“The area we’re drawn to as contrarians is Latin America, just because it’s been so out-of-favour and so hated. It’s an area we’re looking at closely although we haven’t made a specific investment there yet. It’s an area we’re continuing to monitor closely to see whether we do come across an opportunity.”
Thompson admits valuations have cheapened, but he says it doesn’t mean they are going to increase any time soon.
“As we know from this value trade that hasn’t worked over the past five years, valuation isn’t a catalyst. It’s a necessary but not sufficient condition to say it’s cheap, but the catalyst would be a sustained earnings recovery in emerging markets.”
He also points out that this is an issue for all parts of the market, not just commodity-related areas.
“I think the earnings deterioration has been consistent across the board (albeit the magnitudes have been different) because the feedback loop, which is basically the problem with deflation, is commodity prices go down, commodity producers have less money, they import less from other emerging markets and then you find that global trade has slowed and even the commodity importers fund the value of their goods is decreasing.”
“Deflation just flutters through the system and I think everybody has been slightly surprised about how quickly those pass through effects have happened. That’s the problem.”
“Although it would be nice to say commodities have been weak so avoid them because everything else is fine, the deflationary back-drop (and why EM earnings are so correlated to inflation expectations) means if input costs are decreasing, so is global trade.”
Given that information, it is unsurprising that Thompson has largely been avoiding more cyclical areas of the market and favouring defensive growth stocks.
This strategy worked well last year as the £6.7m Neptune Emerging Markets fund ended 2015 in the top decile of the IA Global Emerging Markets sector with a loss of 0.34 per cent, compared to a 10 per cent fall from its MSCI Emerging Markets benchmark.
Performance of fund versus sector and index since launch
Source: FE Analytics
Following a number of difficult years for the fund, however, it is still underperforming both the sector and index since its launch in September 2008.
While the manager isn’t overly optimistic about emerging market equities in absolute terms, he does think they offer more value relative to developed markets.
The graph below shows the relative performance of emerging and developed market equities over the past seven years and, as can be seen, the former has been underperforming on a consistent basis since October 2010.
Relative performance of indices over 7yrs
Source: FE Analytics
Thompson thinks there is potential for that gap to narrow.
“Now, what’s more compelling form my point of view is that emerging markets relative to developed markets is at much more compelling levels.”
“What that does give is that if people do want to make a relative call, then emerging markets do look attractive. If the global backdrop deteriorates, then it is much more priced in to emerging markets than global equities generally and if things improve, then it looks good for emerging markets.”
“I would be hesitant to be banging the table about a bottom in absolute terms, but I would be more comfortable we are close to the bottom of EM relative underperformance to DM because in either scenario it’s hard to see how things get so much worse for emerging markets and it doesn’t affect developed markets.”
